What determines government spending multipliers? Paper by Giancarlo Corsetti, André Meier and Gernot J. Müller Presented by Michele Andreolli 12 May 2014
Outline Overview Empirical strategy Results Remarks
Overview Empirical paper on the government spending multiplier Multiplier is conditional on the economic environment: Exchange rate regime State of public finances Financial crisis
Empirical Problem How to identify government spending shocks Need an exogenous shock, orthogonal to the information set of previous period Identification strategies: VAR with implementation lag of fiscal policy, Blanchard and Perotti (2002), Ilzetzki et al. (2011) Event studies with military expenditures, Ramey and Shapiro (1998) VAR with sign restrictions, Mountford and Uhlig (2009) Internally consistent general equilibrium model, DSGE, Woodford (2011)
Empirical Strategy Two stage approach, Fiscal rule and Panel regression, developed by Perotti (1999) With the residuals from the country specific fiscal rule they identify the fiscal shocks g t,i = φ i + η i trend i + β i,1 g t 1,i + β i,2 g t 2,i + γ i,1 y t 1,i + γ i,2 y t 2,i + θ i cli t 1,i + δ i b t 1,i + ρ i,1 peg t 1,i + ρ i,2 strain t,i + ρ i,3 crisis t 1,i + ε t,i (1) Crucial assumption, no contemporaneous effect from regressors (output) to government spending
Second stage Panel regression (FE) of the effect of the estimated fiscal shock conditional on the environment on various explanatory variable x t,i = α i + µ i trend i + χ i x t 1,i + σ 1ˆε t,i + σ 2ˆε t 1,i + σ 3ˆε t 2,i + σ 4ˆε t 3,i + κ 1 (ˆε t,i d t,i ) + κ 2 (ˆε t 1,i d t 1,i ) + κ 3 (ˆε t 2,i d t 2,i ) + κ 4 (ˆε t 3,i d t 3,i ) + γ 1 d t,i + γ 2 d t 1,i + γ 3 d t 2,i + γ 4 d t 3,i + u t,i (2) d it : exchange rate regime, state of public finances or financial crisis x it : government spending, output, consumption, investment, trade balance, REER, interest rate, inflation
Data 17 OECD countries Annual data 1975-2008 Government spending: volume of final government consumption expenditure No transfers No taxes No automatic stabilizers Composite leading indicator, to identify policy makers expectations on future cycle
First stage results
First stage results
Second stage results Unconditional effect of fiscal shocks in line with common wisdom Multiplier smaller than one, crowds out of investment, reduces net exports, REER appreciates and then depreciates, reduces inflation on impact Conditional effect built on a baseline with flexible exchange rate, sound public finances and no financial crisis
Currency peg vs baseline Multiplier zero with flexible exchange rate, consumption and investment have the same behavior Net export decrease more with peg Monetary policy is less accommodative with pegs (non credible pegs) REER appreciates for peg and depreciates for flexible exchange rate
Weak public finances vs baseline Lower multiplier and more crowding out with weak public finances No effect on impact on consumption, turns positive over time (not good measure of fiscal strain, e.g. Japan) Inflation and interest rate are more pronounced, REER and net export less pronounced
Financial crisis vs baseline Huge multiplier on output and consumption, crowding in of investment, deterioration of trade balance with financial crisis Inflation, interest rate and REER responses are magnified Motive for ex ante fiscal buffer Theoretical reason (liquidity-constrain) or violation of identification assumption of no contemporaneous effect of output on government spending?
Summary of output multiplier Zero on baseline, negative in long run Similar with a peg Fiscal strain make it negative Financial crisis make it big, no long run reduction
Remarks The multiplier is conditional on the economic conditions Exchange rate regime changes the response, support for recent studies that find depreciation after spending increase. That s true for flexible exchange rate Fiscal stimula seem to work in financial crisis and there is a rationale for building a buffer in good times
Thank you!
My remarks 1 The R 2 of the first stage is huge 1. The reason why confidence bands are very small is that they are not identifying a sizable variation in government spending. For Italy R 2 =.99, therefore given that G/Y.2 1, on average the observed shock is 0.2% of Italian GDP Cyclical changes thanks to automatic stabilizers are likely to be on average higher than that. Economically it is more important. 1 Source: OECD Economic Outlook Database: volume of final government consumption expenditure (CGV) and GDP for 2012
My remarks 2 Fiscal stimula seem to work in financial crisis and there is a rationale for building a buffer in good times But what seem to be crucial is the pass-through of the fiscal strain to funding costs A policy prescription would be to make the economy insensitive to fiscal strain (e.g. banking union in EZ)
References - Blanchard, O.J. and R. Perotti (2002). An empirical characterization of the dynamic effects of changes in government spending and taxes on output, Quarterly Journal of Economics, 117(4), November, 132968. - Ilzetzki, E.O., E. Mendoza and C. Vegh (2011). How big (small?) are fiscal multipliers?, mimeo - Mountford, A. and H. Uhlig (2009). What are the effects of fiscal policy shocks? Journal of Applied Econometrics, 24(6), 96092 - Perotti, R. (1999). Fiscal policy in good times and bad, Quarterly Journal of Economics, 114(4), 1399436. - Ramey, V.A. and M.D. Shapiro (1998). Costly capital reallocation and the effects of government spending, Carnegie Rochester Conference on Public Policy, 48, 15494. - Woodford, M. (2011). Simple analytics of the government expenditure multiplier, American Economic Journal: Macroeconomics, 3, 135.